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Will XLY, Consumer Stocks Bounce Back?

Consumer discretionary stocks are the worst-performing of the nine major sectors this year. But there's hope ahead.

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The Consumer Discretionary SPDR (XLY) shed 1.1% through Aug. 6. Sure, that doesn’t sound awful, but it’s far worse than the 5.1% gained by the SPDR S&P 500 ETF (SPY), and makes it the worst performer of the nine major sector ETFs year-to-date, and sixth-worst among the 39 offered by State Street (STT).

XLY consumer discretionary SPDRThe simple answer to the question “Will the XLY recover?” is yes, of course. But that’s not the question that really matters.

The real question is “When?”

Several reasons can explain the underperformance of consumer discretionary stocks and XLY. We’ll look into those, then look at why (and when) things will improve for the sector.

By then, I think you’ll feel better about holding XLY despite its woeful results so far in 2014.

Reasons for Poor XLY Performance This Year

  • The XLY has had a good run. The Consumer Discretionary SPDR achieved a five-year annualized total return of 25.5% through June 30. Only the SPDR S&P Retail ETF (XRT) and SPDR S&P Pharmaceuticals ETF (XPH) outgunned the XLY in the same period. Without trying to oversimplify the subject matter, regression to the mean delivered as it always does, and while it’s certainly not the only reason for XLY going in the dumper, it’s definitely an important one when it comes to consumer discretionary stocks.
  • Top 25 Holdings. A total of 15 stocks in XLY’s top 25 holdings (making up about 70% of its $6.4 billion in total net assets) are in the red in 2014, with Amazon (AMZN), General Motors (GM) and TJX (TJX) all delivering double-digit declines, highlighted by a 21% drop from the world’s largest online retailer. As long as most of its top consumer discretionary holdings are delivering mediocre performance, the XLY is naturally going to tread water.
  • Economy Still Soft. Jonathan McCarthy, an economist with the Federal Reserve Bank of New York, wrote a blog post Aug. 6 that does a great job explaining why the economy is still sucking gas despite recent signs it’s heating up, if ever so slightly. It seems consumers aren’t spending nearly enough to move the needle, and that’s keeping consumer discretionary stocks down. Consumers are feeling totally insecure about their future prospects both in terms of employment and the ability to grow their income. The employment rate — which is defined as the number of people employed divided into population — for people ages 25-54 currently sits at 76.6%, 310 basis points lower than where it was before the recession began. Add to this a widening income gap that provides comfort to only the 1% club, and it’s not hard to understand why there are headwinds facing consumer discretionary stocks.
  • Empty Holiday Shelves. 120 truck drivers at the ports in both Los Angeles and Long Beach picketed for five days in July. Bloomberg reports that the 7,000 longshoremen at these ports could decide to join them on the picket lines. If these longshoremen, who have been without a contract since July 11, strike or carry out some kind of work disruption, we could be looking at a bleak holiday season with empty shelves and tumbling profits. That’s definitely something that could weigh heavily on consumer discretionary stocks and the XLY.

Why Consumer Discretionary Stocks Will Rebound

I’ll grant you it’s not looking promising for consumer discretionary stocks at the moment and likely for the remainder of the year.

However, if you currently own XLY, the worst is probably already in the books.

In the first quarter, the XLY declined by 2.9% — the third-worst quarterly performance since the beginning of 2010, and the first negative quarter since Q2 2012. The chances of a double-digit quarterly decline like those in 2011 and 2010 seems unlikely.

That’s because Q2 earnings for consumer discretionary stocks in the S&P 500 have been relatively successful. Of the 49 consumer discretionary stocks to report so far (as of Aug. 4), 69% either met or exceeded analyst expectations for the quarter. With another 35 still to report, the trend appears to be in the right direction. Especially important is the earnings growth rate, which came in at a sector-best 22.9% — 580 basis points higher than analyst expectations.

So, while consumer discretionary earnings have been a little shaky so far in 2014, generally they’re still positive.

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